Game Changers

The Indian diamond industry is reeling under the pressure of a new import tax on polished diamonds and the sharp depreciation in the rupee.

By Dilipp S Nag

As India, the world’s largest diamond cutting and polishing center, moved into the second half of 2012, it was facing two unexpected challenges. As if concerns about the weak global economy and tight liquidity worldwide were not enough, Indian diamantaires were reeling under the pressure of a new import tax on polished diamonds implemented in January 2012 and the currency depreciation that has riled the domestic financial market in recent months.

The two unrelated events have thrown the $43 billion Indian gems and jewelry industry — a rare bright spot of continuous growth in a depressed world market — into a tailspin. The tax sent diamond import and export volumes plummeting, and the weakened rupee translated into costlier imports, since diamond dealers’ foreign trade is in dollars, and higher costs for thesmaller manufacturers and dealers in the domestic market, who do business in rupees. As a result, dealers have cut down their rough buying, or deferred their purchases altogether for fear of incurring losses on the resulting polished goods.

IMPORT DUTIES

The government had abolished a previous 3 percent import duty on polished diamonds in May 2007, as part of an effort to attract more diamond trade to India and better position the country as an international diamond trading hub. But, in January of 2012, the government imposed a 2 percent tax on the import of cut and polished diamonds — surprising many in the diamond industry. According to trade officials, the government’s move was aimed at curbing the widespread practice of “round-tripping,” where companies seek to boost their turnover numbers — and then qualify for additional bank financing — by the frequent import and export of the same diamonds. Some of the companies indulged in round-tripping with their overseas affiliates with the understanding that the goods would be bought back at a pre-decided price at a later date to boost their turnover and artificially inflate their balance sheets in order to procure cheap bank financing, which is generally based on invoiced transactions.

As a result, the country’s polished exports surged to $27 billion in 2011 from $13.21 billion in 2007, while polished imports jumped to around $20 billion from $4.75 billion during the same period, according to data from the Gem and Jewellery Export Promotion Council (GJEPC). At the same time, the trade numbers of the overseas affiliates also increased.

DEVASTATING IMPACT

The introduction of the import tax earlier this year has helped curb round-tripping, but it also has penalized companies bringing polished goods from their own overseas factories to India. Since the tax, trading volumes have plummeted. The country’s polished imports declined 70 percent year on year to 7.9 million carats, while polished exports fell 51 percent to 17.6 million carats during the first half of 2012, according to GJEPC data.

According to Alok Dugar, a partner at Royal Diam, fewer Indian traders are traveling to Hong Kong, Tel Aviv and other centers to buy polished goods that they can bring back to India in order to sell to others. The industry saw its trading volume rise dramatically after India removed the import duty in 2007 but now it will come back to more realistic levels and this will also impact the volumes of trading partners in other countries as Indian diamantaires are importing fewer goods, Dugar notes. In addition, depressed trading in an already weak market puts added pressure on polished prices.

Hitesh Shah, a partner at Venus Jewel, notes that Indian companies who want to avoid the tax have the option to send goods manufactured at their overseas factories directly to buyers or to their own offices in Dubai, Hong Kong or any other center to avoid bringing goods into India at all. “Until now, I was bringing polished goods here from my overseas factory but I am trying to organize something abroad,” says a Mumbai-based diamantaire, declining to be identified. “If I bring the goods here, then my costs will rise unnecessarily because of the import tax.”

CURRENCY SLIDE

But the new import duty is only the first challenge facing Indian diamantaires. The second is the sharp depreciation of the Indian rupee against the U.S. dollar that began in August 2011. In hitting its all-time low of 57.32 to one dollar on June 22, the rupee has lost more than 15 percent value since February 2012, when the exchange rate was 49.53 rupees to one dollar.The rupee has recovered from its record lows but the exchange rate volatility continues. In the past year, the rupee has been the worst-performing currency in Asia, reflecting investor concerns about India’s economy, which is suffering from high inflation and slowing growth. India’s current account deficit (CAD) — which occurs when a country’s total imports of goods, services and transfers are greater than exports — hit a record $21.7 billion, or 4.5 percent of gross domestic product (GDP), in the January to March 2012 period, exerting further downward pressure on the rupee.

Madan Sabnavis, chief economist at CARE Ratings, India’s second-largest credit rating agency, notes that weak domestic fundamentals because of capital outflows by foreign institutional investors (FIIs) funds and the strengthening of the dollar against the euro are the main reasons for the rupee depreciation. “Overall sentiment is not as good as it was earlier,” Sabnavis says. “There is a lot of skepticism as to what India’s growth prospects will be, what kind of policies will be pursued and whether the government will be able to stick to its fiscal deficit, high inflation and higher interest rates.”

Measures by the Reserve Bank of India (RBI) on investments and earnings, undertaken to arrest the rupee fall and boost the economy, have failed to achieve the desired results. “The measures announced by the RBI have not improved sentiment or fundamentals in a significant manner,” Sabnavis notes. “Under these circumstances, the rupee will continue to be under pressure.”

DOUBLE WHAMMY

According to Vijay Jain, chief executive of Orra, the diamond jewelry retail chain of Rosy Blue Group, the rupee depreciation is like a double whammy for the industry, which is already facing the pressure of slowing sales growth in Europe and Asia due to weak consumer sentiment. The uncertainty of rupee-dollar pricing has also impacted dealers’ willingness or ability to carry inventory, he notes.

The current situation has further aggravated the tight liquidity situation in the market, as lenders have turned cautious amid concerns about the domestic and global economy. “We are not processing the new loan requests very aggressively because the market condition is not right and in this type of market no one wants to take risk,” says a senior bank executive, who requested to remain anonymous.

Rajiv Jain, GJEPC chairman, says that India’s gems and jewelry exports could be around $32 billion to $35 billion this year, down from around $43 billion in fiscal 2011-12, as round tripping has almost stopped. The manufacturing export activity is picking up, which is good for the industry, he notes. Industry officials, however, remain worried, given that there is no sign of stability in the rupee-dollar exchange rate. Tight liquidity and the impact of import duty on business and on India’s significance as a leading trading center are also risk factors.

Article from the Rapaport Magazine - August 2012. To subscribe click here.